Liquidity Research in Bitcoin Options Market

On December 28, the "2021 First Digital Finance Frontier Academic Conference" was successfully held online. The conference was hosted by Tsinghua SEM Digital Financial Assets Research Center and chaired by Professor Luo Mei, director of the center.

Wang Yintian, associate professor of the Department of Finance, School of Economics and Management, Tsinghua University, and core researcher of the Digital Financial Assets Research Center, delivered a keynote speech entitled "Liquidity Research in the Bitcoin Options Market". This article is organized according to the content of the speech.

First point out that this is an empirical study on the Bitcoin capital market. There are two keywords in this research, one is market illiquidity, the other is options, the pricing mechanism of market illiquidity or liquidity for option price, pricing mechanism, or how to affect option price.

The recent research direction of Bitcoin is to regard Bitcoin as a financial asset, but obviously it is not a financial asset. The pricing mechanism of Bitcoin itself is completely different, but the pricing mechanism of cryptocurrency derivatives is different from traditional ones. Derivatives are very convergent, so we can start with that and conduct research.

The research attempts to answer three questions about the cryptocurrency options market:

1. How does the buying and selling direction of end-users affect the formation of Bitcoin options prices?

2. Are there more buyers or sellers in the Bitcoin options market?

3. How does market liquidity affect option prices under end-user trading pressure?

Let's take a look at how the trading direction of the end-user (end-user) in the stock market affects the stock price. For stocks, its end-user must be the buyer, and it is the buyer who bears this liquidity risk. The worse the liquidity, the lower the price. In the end, its price will return to the real price, so its expected return and rate of return will be higher. For options, it is essentially an insurance contract. It is not like a stock, which can only be issued by a company, but any market participant can issue an option.

If a buyer goes to the market to buy options, the market maker will issue options and sell them to me; if I am a seller and sell options in the market, I can issue and sell them to the market maker myself. Therefore, in the options market, in theory, there will be no shortage of supply or oversupply, and buyers and sellers are actually cleared.

Excess positions are taken by market makers and hedged through some methods or trading strategies. So who decides the option price? In reality, it is impossible for a market maker to hedge his position at zero cost. When the liquidity is not good or the market maker must have a cost when hedging his position, how can he compensate himself? This will have an impact on the price, which is the mechanism of how liquidity affects option prices in the options market.

Liquidity Research in Bitcoin Options Market

When the liquidity of the market is not good, the market maker will have to sell when faced with more buyers and will raise the price, which will have an effect on the price of the option. If there are more sellers in the market, the market maker as the buyer will push down the price, which will have a lowering effect on the option price. That's the heart of the whole story.

How liquidity affects the price in the option market also depends on the direction of the end-user: if the end-user is the seller and the market maker is the buyer, he will lower the price to compensate for the lack of liquidity, resulting in The premium or expected rate of return is positive. If the end user is the buyer and the market maker is the seller, the option price will be raised, resulting in a negative expected rate of return.

Liquidity Research in Bitcoin Options Market

Are there more buyers or more sellers in reality? This is a question we will look at, there is a paper on Cryptocurrency options research and found that the largest options market at the moment is more buyers.

In order to do better research, we must define several important variables. One is illiquidity. The general method of illiquidity is the bid-ask spread of options. We use Effective Relative Spreads (ERS) to define, for The degree of option price volatility, we use the excess implied volatility (Excess Implied Volatility, EIV) to measure.

Liquidity Research in Bitcoin Options Market

We currently have three findings:

1. How do market makers protect themselves when there is liquidity risk in the market? In general, no matter there are more buyers and more sellers in the market, the market maker will increase the spread to protect himself, especially when there are more sellers in the market, he will increase the spread to protect himself. ;

2. In addition to widening the spread, what other ways can market makers protect themselves? One assumption is that when the market liquidity is poorer, the higher the Effective Relative Spreads (ERS) will be, which will lower its price, because the market maker has to face more sellers, and he will lower the price. Through the regression analysis of the model, it is found that under the condition of illiquidity, when the market maker is faced with seller pressure, it will indeed make it lower the price.

3. Since LedgerX allowed more small traders or individual traders to enter the platform on August 1, 2019, through the regression analysis of the model, it was found that individual investors not only brought trading volume, but also made the market more Efficient, more mature, and more oriented towards a mature stock market.

To sum up, in the over-the-counter (OTC) market, there are more sellers and there is seller pressure, and more investors use the covered call strategy; market makers face seller pressure. In order to protect themselves, on the one hand, the bid-ask spread will be widened, and on the other hand, the option price will be lowered; finally, the introduction of small traders or individual traders (Retailers) can make the market more mature. (Digital Financial Assets Research Center)